When participating in Market Making activities on Magic Eden, it is essential to understand the concept of impermanent loss. Impermanent loss is an unavoidable risk when providing liquidity to an AMM pool.
What is Impermanent Loss?
Impermanent loss occurs when the price of the assets you deposit into a liquidity pool changes compared to when you initially deposited them. The bigger the price change, the more you are exposed to impermanent loss. The term "impermanent" is used because the price of the asset could return to the original price when you deposited it into the pool. However, if the price does not return to the initial price, impermanent loss becomes permanent loss.
For example, suppose you deposited 20 non-fungible tokens (NFTs) into a liquidity pool with a 5% difference. If the price of the NFTs increases tenfold from the initial price, you may experience impermanent loss. This is because you would have been better off holding the NFTs rather than selling them along the way. However, the price of the NFTs could decrease, and the impermanent loss would no longer be a loss.
Opportunity Cost in Impermanent Loss
In addition to the actual loss of value due to price changes, there is also an opportunity cost associated with impermanent loss. When you deposit assets into a liquidity pool, those assets cannot be reallocated to potentially better-performing assets. This can result in missed investment opportunities and lower returns.
How to Mitigate Impermanent Loss?
It is not possible to completely eliminate the risk of impermanent loss, but there are ways to mitigate it. One way to reduce impermanent loss is by selecting liquidity pools with assets that have lower price volatility. For example, NFTs with stable prices tend to have lower price volatility than NFTs with more variable prices. By selecting a liquidity pool with NFTs that have stable prices, you can reduce your exposure to impermanent loss.